Euro indices battle it out

Many thousands of indices are calculated daily by the large index providers, yet only a few are used as the basis for structured investment products. But as investor knowledge deepens, this could well change. Patrick Fletcher reports

The European index market is undergoing a period of increased competition, as index providers strive to create more accurate, innovative and desirable indices. On January 31, Euronext officially launches NextCac70, a new tradable index of European blue-chip companies that covers the top 70 companies from the Amsterdam, Lisbon, Brussels and Paris markets. Euronext says the index has been designed to serve as the basis for exchange-traded structured products, but it is being launched into a crowded market, and its success in the retail sphere may well hinge on how quickly Euronext can make the name a known and trusted brand.

So far, market participants appear to be interested in using the index. Wilco Jiskoot, managing board member at ABN Amro, for example, says the “marked emphasis” on tradability in the construction of the NextCac 70 is particularly important because “tradability opens up opportunities for creating index-linked products”. A basic structured product using the index as its underlying could, for example, be a principal-protected note with the participation partly linked to the upside of the NextCac 70.

But considering that the number of indices calculated on a daily basis in Europe runs into six figures, the dominance of a mere handful is perhaps surprising. It will be interesting to see if the NextCac 70 can make inroads into the market.

Brand identity

For retail clients, the most important thing when investing in a structured product is their knowledge of the index. Not necessarily its methodology, or sometimes even its components, but the trust they place in its continued appearance in the press as a national or global benchmark is what appears to matter. “The reason why the FTSE 100 has been so popular,” says Jim Goddard-Jones, head of third-party distribution at the UK’s Bristol and West, “is because it’s almost like a brand. Arguably, it’s the only index which a large proportion of customers in the UK understand.”

Figure 1 illustrates the FTSE 100’s popularity. Of the 1,631 products launched in the UK retail market over the past four years, 1,078 were linked solely to the FTSE 100 and a further 302 used it as a component within a basket of underlyings. Compare this with France, where the introduction of the Eurostoxx 50 has pushed the country’s domestic champion, the CAC40, into second place (see figure 2, p.16). Despite this, the French market still uses an increasingly wide spread of indices, including a jump in the issuance of share basket-linked products.

Goddard-Jones warns that selecting indices for their brand value alone can be risky, since they may not possess solid growth opportunities. “Some indices have a positive feel, and some have a negative feel, and this won’t necessarily match up with the relative prospects for that index. You find some customers will be opposed to having the Nikkei225 in a product, for example, because that index has a negative perception.

This, of course, may not actually relate to the underlying fundamentals of the index or the market it’s covering,” he says. At the same time, he says some of the larger independent financial advisers (IFAs) often have preferences relating to index choice: “They sometimes relay preference to us based on their own research, saying they prefer Stoxx to SMI, as an example, which we take on board.”

In markets where the index is even less well known to the retail customer, providers often find it useful to explain more about the stocks in the index. “An index company such as FTSE can put the FTSE name on all of its products, but it doesn’t mean people will be comfortable. Where we have in the past used an index which is not so well known, such as the Swiss market index, we’ve made an effort to give some examples of the companies within it, so people can see what they’re buying into,” Goddard-Jones says. Some companies have gone a step further and removed the index from the product altogether, releasing bonds linked to a basket of blue-chip equities.

Basket case

Newcastle Building Society released a bond linked to a basket of 20 blue-chip stocks in June 2004. “There are some customers out there who fully understand what the FTSE 100 is and how it works. But there are also some who can relate more easily to a basket of blue-chip stocks,” Steve Urwin, head of marketing at Newcastle says. The stocks chosen included well-known names such as McDonalds, HSBC, Nokia and Disney. According to Urwin, the issue fared just as well as the FTSE 100 bonds the society releases. However, the statistics for the number of share baskets released shows a drop from 19 in 2001 to a mere four last year.

Others are much more cautious about stock selection. Anthony Green, business development manager at London-based Nvesta, is wary of not using rules-based selection due to the added risk. “Choosing baskets of shares is not widely accepted in the retail market,” he says, “Partly because IFAs tend to remember products which lost money in the precipice bond saga.” This problem also spills over into indices. Green cites the Nasdaq as a victim of the bursting of the technology bubble: “The Nasdaq has a good name, which is important for an index, but there is the problem that people have been burned on it before.”

Another issue that can be problematic for less-well-known indices is liquidity. Market participants agree that it is easy to get a competitive price from a range of banks for the main indices, whereas for a more exotic product, one may only be able to find a single quote. New indices sometimes stumble as banks feel they haven’t got enough historic data to be confident about their pricing, say market participants.

Ahead of the game

Index providers are keen to stay ahead of investment trends and can leverage their brand when looking into new areas of investment. “In the UK, we don’t have to spend time anymore promoting the FTSE 100 as the benchmark for market reporting,” says Peter de Graaf, managing director of FTSE for Europe, the Middle East and Africa. He now spends his time promoting non-UK indices – where competition is much stronger – and looking for new areas in which to expand. “Sometimes, we feel very strongly about a certain area; four years ago, it was China,” he says.

FTSE set up a joint venture with the Xinhua news agency, and now produces two major indices: the FTSE Xinhua 25, consisting of Hong Kong-listed red-chip and H-shares, and the FTSE Xinhua A50, consisting of mainland-listed shares that can only be bought by domestic investors or qualified foreign institutional investors (QFIIs). De Graaf points out, however, that this move wasn’t driven by clients. “It was more a case of us believing that we should be there now, and that the demand will come in two or three years time,” he says.

But some competitors believe the indices have problems. Chris O’Brien, Paris-based vice-president for European and Asian marketing at Standard & Poor’s (S&P), says the Xinhua, which for the UK retail customer is the Xinhua 25, isn’t a fair reflection of China. “The fallacy about China,” he says, “and we’re in a market where there is a lot of fallacy, is that nobody offshore can buy what they want to on the mainland. Looking at the FTSE Xinhua 25, it’s a red-chip and H-Share index; i.e. Chinese companies that have a listing on the Hang Seng stock exchange. The fallacy is that they’re not buying China, they’re buying Hong Kong.” The problem, however, is that nobody outside of China is allowed to buy A shares, except the QFIIs, and the allocation allotted to them by the authorities is a mere $4 billion, which they tend to keep for themselves.

S&P itself is also trying to spot the next market opportunity. On December 3 last year, it signed a memorandum of understanding with the Russian authorities and will be rolling out tradable indices on that market in the near future. It also has agreements with India Index Services and Products to run the Nifty 50 index in India and with Citic Securities to run indices in China.

Stoxx also has projects that it thinks will take off, such as its brand new EU Enlarged blue-chip index, which measures the performance of the 15 largest companies from the latest EU entrants. “We used the same idea as the Eurostoxx 50 for this index. Why have 100 names when, with only 15, we can capture 70% of the market capitalisation,” says Lars Hamich, Frankfurt-based managing director of Stoxx. He notes that there have already been a couple of products listed against it.

Meanwhile, FTSE is banking on the continued growth of the Xinhua series as well as FTSE Hedge, its new hedge fund index. De Graaf is also confident that there will be more uptake of Eurofirst. But he is not so bullish about the FTSE4Good index. “It’s a very specific niche,” he says, “and you have to get specialised investors to launch products against it. It’s got a massive profile, and there is everything in place to allow people to list products against it. It’s got the name recognition, it’s got the real-time technology, and we’re finding that it has a steady take up, but not as spectacular as, say, the Xinhua.”

Hamich believes there are further opportunities for investors branching out of the headline indices. “I think we’re going to see the concept of mid-, small- and large-cap products taking root. There was a lot of talk about mid-cap doing better than the large-cap and small-cap doing better than the mid-cap, and this is something we may see,” he says. He also believes that passive products, such as certificates and exchange-traded funds, will continue to grow. “I think some of the asset managers have to realise they can no longer charge active prices for passive products – which is a good thing,” he says.

The Stoxx revolution

The launch of Stoxx in February 1998 as a joint venture between Dow Jones, Deutsche Börse and the Swiss exchange, SWX, changed the nature of the index business. Prior to its launch, the major index providers, FTSE, MSCI and Standard and Poor’s (S&P), all ran their businesses mainly from selling data to financial institutions. However, in 1997, Dow Jones, a firm which formerly only calculated its indices for illustrative purposes, decided to start licensing them. Stoxx brought a new business model to the market by offering all of its data for free and making money only by licensing the use of the index for derivatives, structured products and so on. Stoxx introduced a new series of indices, including the EuroStoxx 50, at a time when the single currency was preparing for launch. “Everyone was talking about the Eurozone at the time, which definitely helped,” says Lars Hamich, Frankfurt-based managing director of Stoxx. “We wanted to offer something that would encourage people to go abroad, and you can’t expect them to do that if you give them something that they don’t know. If you look at the names of the EuroStoxx50, it is full of companies that you know – Peugeot, HSBC, Deutsche Telecom, etc. It is a lot easier to persuade people to invest in the best-known 50 names in Europe than the best known 400 names.” Hamich claims that his rivals at MSCI, FTSE Europe, and S&P missed an opportunity. “They were all there, but no-one was using them because they were too broad. People couldn’t really relate to the names. You had French small cap, UK mid cap’ so what? It doesn’t mean a thing to an Italian investor,” he says. Stoxx also drove innovation in the market by being the first to move its indices to ‘free float’, a system that excludes illiquid shares from a company’s market capitalisation, and therefore from its index weighting as well. “We moved to free-float first and the other index companies had to follow whether they liked it or not. It was really interesting to see the other companies struggle to migrate their indices across and it took some four, maybe five years to make that change. FTSE had a hard time, for MSCI it was even more difficult,” Hamich claims. But there are problems associated with using too few names. When FTSE launched its FTSEurofirst index series in 2003, it used 80 stocks. Peter de Graaf says this was in response to client demand for a broader index: “Eurofirst was launched partly in competition with Stoxx, but mainly driven by client feedback. They complained that 50 names is a bit narrow for a European basket and wanted a broader basket, so you could have some decent weights for different countries and different sectors. If you look at Europe as a whole, the 80 stocks are still very liquid, but slightly wider than Eurostoxx.” The methodology of the FTSEurofirst 80 is slightly different to that of the Eurostoxx 50. “What we have done with FTSEurofirst,” de Graaf says, “is look at the sector breakdown and structure an index in such a way that, if you use a derivatives product, the tracking error with the global benchmark is much smaller, so it is a much cheaper contract to run.” This has been achieved through using the bottom 20 stocks in the index to rebalance the sector weighting. “We haven’t merely gone for the biggest 80, we have the biggest 60 and then some sector weighting,” he says.